On September 16, 2014, in VirnetX, Inc. v. Cisco Systems, Inc. (Fed. Cir. 2014), the Federal Circuit Court of Appeals partially upheld the district court’s ruling of patent infringement for VirnetX against Apple and Cisco based on Apple’s FaceTime and VPN On Demand products. However, the Court determined that the jury award of $368 million was excessive and based on flawed damages calculations presented by VirnetX’s damages expert during trial because the calculations relied on the entire value of Apple’s products. The Court remanded the case back to the district court to recalculate damages based on an approximate value apportioned to the infringing components of the products sold by the defendants.

The decision is notable because it clarifies the proper method to calculate a reasonable royalty in determinations of patent infringement for multi-component devices involving hardware and software. Royalty calculations that are based on the entire market value (or sales price) of the accused product — rather than the value of the allegedly-infringing technology — are routinely being rejected by the courts. This is especially true for mechanical and electronic devices, where allegedly-infringing products usually include a large number of interconnected components.

In VirnetX, the Federal Circuit grounded its decision on Section 284 of the Patent Act, which provides:

Upon finding for the claimant the court shall award the claimant damages adequate to compensate for the infringement, but in no event less than a reasonable royalty for the use made of the invention by the infringer, together with interest and costs as fixed by the court.

35 U.S.C. § 284.

When dealing with multi-component devices, smartphones, and computer components, calculating the “reasonable royalty” for the specific component encompassing the infringed invention — as opposed to the overall, multi-component product — can be difficult. This can occur, for example, when the infringing product or component does not have an actual, separate price or recorded apportioned cost that can be used as a royalty base price.

In this case, VirnetX alleged that Apple’s FaceTime application and VPN On Demand application infringed on a number of its patents (U.S. Patent Nos. 7,418,504 and 7,921,211 by FaceTime; U.S. Patent Nos. 6,502,135 and 7,490,151 by VPN on Demand). VirnetX alleged that both of Apple’s applications were native applications included in Apple’s iOS operating systems that came pre-installed in its line of consumer electronics hardware, including iPhones, iPods, iPads, iMacs, and MacBooks. VirnetX’s damages expert testified to three alternative methods for calculating damages for the infringing Apple’s iOS programs. Plaintiff prevailed on most of its infringement claims and the jury awarded $368.2 million in damages.

The Federal Circuit reversed the damages award and rejected each calculation method presented by VirnetX’s expert.

  1. Estimated Royalty Base — the “Entire Market Value” and “Smallest Salable Unit”

35 U.S.C. § 284 requires that the reasonable royalty be for use of the invention by the infringer. Courts have interpreted this requirement as to require the parties to provide evidence of a reasonable royalty rate and a proper determination of an estimated royalty base price based on apportionment, such that the reasonable royalty is only applied to the portion of the infringing product that is actually related to the invention, as opposed to the price of a product as a whole.

Apple challenged both the royalty base and royalty rate used by VirnetX in its damage calculations. The Court ruled that VirnetX’s use of a 1 percent royalty rate was proper, as VirnetX provided evidence that it maintained a policy of using a 1 percent product rate, as shown by six corresponding licenses in similar negotiations for other patents.

However, the Court rejected VirnetX’s royalty base as excessive. VirnetX’s expert attempted to exercise one of the exceptions to the apportionment requirement when calculating the royalty base, which the Court deemed improper. The expert presented calculations that cited two exceptions to the apportionment requirement: (1) the Entire Market Value Rule and (2) Smallest-Salable Unit.

Earlier court decisions have repeatedly stated the Entire Market Value Rule exception only applies in instances where the patented feature was driving the demand for the entire multi-component product. However, the instructions provided to the jury in this case presented both the Entire Market Value Rule and the Smallest-Salable Unit calculations as distinct exceptions to the apportionment requirement that could be applied independently in separate damage calculations. The Court concluded that the jury instructions misstated the law, as the Court clarified that the “smallest-salable unit” was to be used as a better starting point from which to apportion the patented features contribution. The Court illustrated the difference by noting that the smallest-salable unit calculation would start at the iOS operating system price of $29, as opposed to the entire iPhone product of $650, from which the expert was to have apportioned the contributions of FaceTime and VPN On Demand to the unit price of $29.

The Court concluded that VirnetX’s expert erred in using the entire market value of Apple’s products as part of one of his calculations, as the expert did not present any supporting evidence that the FaceTime and VPN On Demand features drove demand for those products. Without such evidence, VirnetX’s expert should have been restricted to calculations based on the apportionment of Apple’s product prices to the FaceTime and VPN On Demand applications. The Court stated that the use of the smallest-salable unit without an apportionment calculation can only be applied in instances where the smallest-salable unit only includes the patented feature; otherwise, the plaintiff must do more in its process of calculating damages to limit the smallest-salable unit to only the portion that is attributable to the invention.

The Court concluded that VirnetX’s expert failed to even estimate the smallest salable unit based on available prices for other Apple product prices (e.g., the price of the iOS by itself, of which FaceTime and VPN On Demand are smaller components). The Court reasoned that the expert should have used apportionment on the smallest unit price when generating his damage calculations. Due to the expert’s failure to properly apportion the per-unit price to the infringing applications, the Court ruled that VirnetX’s expert’s testimony should have been excluded.

  1. Nash Bargaining Solution

The Court similarly rejected alternative damage calculations presented by VirnetX’s expert based on the Nash Bargaining Solution, which is a game theory method used by some experts to calculate patent damages. Experts use the Nash Bargaining Solution to determine the outcome of a hypothetical negotiation between the plaintiff and defendant for a license to the infringed patent. As it is not feasible in most situations to determine an actual royalty rate or lump-sum (as the price or rate was never agreed-upon) that would result from the hypothetical negotiation, the Nash Bargaining Solution uses an assumed environment to envision what the hypothetical successful outcome would be.

The Nash Bargaining Solution assumes that in a bargaining problem, the solution to the problem (i.e., the resulting price or rate) would satisfy certain requirements, for example, that parties would receive a good return (i.e., profits from a product) only if a mutual agreement is reached.  In similar patent damages cases, experts have determined that the Nash Bargaining Solution would result in a 50/50 split between the plaintiff and defendant of the profits related to the negotiated patented technology.

The Court found that the Nash Bargaining Solution is based on a list of premises such that application to any patent infringement scenario is only a rule of thumb, akin to the “25 percent rule” for royalty rates that has similarly been rejected by a string of cases by the court. The Court ruled that VirnetX’s expert failed to provide any evidence to suggest that the situation between VirnetX and Apple was in fact similar to the premises assumed by the Nash Bargaining Solution.

Conclusion

As demonstrated in this case, the Federal Circuit has emphasized that damage calculations in patent infringement cases must be based on rigorous efforts to assess royalty rates based on apportionment, that is a close fit between the royalty rate or per-unit royalty amount to the actual cost of the infringing component. The emphasis on apportionment will likely limit damages in future cases, as plaintiffs must provide ample evidence to show that a certain infringing feature either was a major apportioned value of the overall price or that the feature had an actual impact on the price of the infringing multi-component product to drive the value of the entire product or some large portion of it. Further, limitations on damages may encourage defendants to determine potential damages in a case earlier, as smaller damage ceilings may alter the parties’ strategy during litigation.